Hey, Money-Market Funds, the SEC's Your Pal

The Securities and Exchange Commission is supposed to help protect investors from the risk of financial crises (among other things), so it's disappointing that the agency is planning to exempt many money-market mutual funds from regulations that would serve this purpose.

Like other mutual funds, money-market funds issue shares and pay dividends. Unlike stock and bond funds, the money funds peg the value of their shares at $1 and offer people the convenience of a typical checking account, except with higher yields. This threatens the safety of the financial system.

Don't take my word for it: The risks posed by money-market funds are one of the few things that every regional Federal Reserve Bank president agrees on. The promise to redeem shares for $1 encourages investors to believe that money funds are as safe as bank deposits -- even though deposits pay lower interest rates and come with explicit government guarantees. The $1 shares are backed by short-term debts issued (mostly) by financial firms. They are fairly safe, but fairly safe isn't safe.

Money-fund shareholders were quick to get their cash out when they realized their $1 shares might end up being worth only 95 cents or less after Lehman Brothers Holdings Inc. went bankrupt. The outflows were so big that the government was forced to guarantee the more than $3.3 trillion held in those instruments against losses. Large-scale redemptions during the crisis were, in effect, the same as a bank run.

Money funds also encourage the big banks to issue too much short-term debt. Scholars have found that changes in short-term bank debt (excluding old-fashioned deposits) predict financial crises; and researchers at the Federal Reserve Bank of New York have shown that "a banking system intermediated through MMFs is more unstable than one in which investors interact directly with banks." If there were no money funds to buy those systemically dangerous instruments, banks would issue fewer of them.

The obvious way to make money funds safer would be to forbid the $1 peg on their share price. (It isn't the only possible approach: Here's another.) Regulators are expected to do this for funds used by big companies, insurers and pension plans but they're planning to exempt funds marketed to individual savers. It's true that the big outflows during the crisis were driven by institutional investors rather than individual savers, but past performance is no guarantee of future results.

(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter.)

To contact the writer of this article: Matthew C. Klein at mklein62@bloomberg.net.

To contact the editor responsible for this article: Clive Crook at ccrook5@bloomberg.net.

Matthew C. Klein writes for Bloomberg View about the economy and financial markets. He previously wrote for the Economist magazine and its economics blog, Free Exchange.
Before that, Klein was a research associate at the Council on Foreign Relations, where he spent more than two years studying the history of the Federal Reserve and the intellectual history of monetary economics for an upcoming book by Sebastian Mallaby. He also worked at Bridgewater Associates, where he studied the economies of Central and Eastern Europe and advised institutional investors on asset-liability management. Klein has a bachelor's degree in history from Yale University. Originally from Chicago, he lives in New York.
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